During the dark ages of economics, the quantity theory of money held forth that the amount of money swooshing through the economy determined everything from inflation to economic growth. An excess supply of money available to the public would chase a limited supply of goods, inducing higher inflation and thereby limiting growth.
Broad changes to society have all but ended the idea that inflation is always and everywhere a monetary phenomenon.
The changing structure of the economy, the integration of advanced technology into the production of goods and provision of services, and broad demographic changes have all contributed to the conditions that have all but ended the idea that inflation is always and everywhere a monetary phenomenon.
As monetarism faded into the background, modern monetary policy became centered on inflation-targeting via central bank manipulation of short-term interest rates.
In the United States, the Federal Reserve settled on a dual mandate of maintaining price stability while minimizing unemployment. After all, an hour of unemployment can never be recovered, forever subtracting from an economy’s potential growth.
More recently, the Fed changed its long-term strategy and will no longer engage in preemptive rate hikes to quash the first signs of inflation. Rather, it will engage in average inflation targeting, which will focus on full employment and seek to target a 2% inflation rate over a period of years.
Velocity of money’s decline
Not surprisingly, the cousin of monetarism and a focus on the money supply, the velocity of money, has experienced a historic decline implying slower growth due to the broad and deep shock caused by the pandemic.
Although the money supply no longer has the attention of the financial markets or the monetary authorities — think of the emergence of credit cards and how little cash you carry around in your wallet these days, and think of how often you pay for something with a check — we still keep track of what are referred to as money aggregates.
There are several measures, beginning with M1, the amount of money readily available to the public, defined as the amount of cash plus demand deposits (checking account balances).
Next up is the M2 money supply, which equals cash plus checking account balances plus savings deposits. M2 is the benchmark we will discuss because of the unique importance of savings deposits during the pandemic or any other economic downturn.
M2 is growing at a rate of 23% per year. Was the economy suddenly awash in the cash that had been stashed in mattresses?
In the first figure below, we show the growth rate of M2 money supply during recessions and recoveries, with sharp increases in M2 occurring at or near the outset of the 1990, 2001 and 2008 recessions and again at the end of 2019 as the global manufacturing recession took hold. That threat to the global economy was quickly followed by the global economic shutdown at the onset of the coronavirus pandemic.
M2 is growing at a rate of 23% per year. Was the economy suddenly awash in the cash that had been stashed in mattresses from Hoboken to Hollywood? Has the public been waiting for the bottom to fall out the economy all this time?
Probably not! In fact, the amount of currency put into the economy is mostly irrelevant these days. Again, think of credit cards and buying things with your smartphone.
Instead, the second chart shows that the growth of M2 in the modern era of digital spending (probably beginning around 2005 and becoming full-blown in the 2010s) is determined by the growth of savings deposits. In the current episode since 2012, the growth of savings has been nearly identical to the growth of M2 money supply.
The paradox of thrift
So why do you think that savings deposits would grow during times of distress? We’d argue that the propensity to save (and not to spend) grows when economic uncertainty increases.
A household is more likely to restrict spending to essential items (food, rent, utilities, car payments and health care), saving whatever might be left over just in case things get worse. In other words, it’s the same challenge that faced the economy during the Great Depression, or what is known as the “paradox of thrift.”
As soon as a recession is over, overdue bills are paid and spending on non-essentials becomes possible again.
That seems to be confirmed by the decrease in savings deposits after each of the recessions. As soon as a recession is over and a household income stream becomes secure, overdue bills are paid and spending on non-essentials becomes possible again, with the depletion of savings adding to the economic boom.
The propensity to save and spend have ramifications for public policy during a pandemic. We’ve talked before about the spending attributes of lower and upper-income cohorts. Those at the bottom of the earnings ladder typically spend more than their salaries, with the difference made up by social safety-net benefits.
Each dollar of income made available to the lowest-earning cohorts is spent on putting food on the table and other essentials of life, with each dollar spent generating additional income and spending along a stream of commerce. Members of the lowest income group would be expected to have little or no savings to get them through an economic shutdown, and it is that group that needs the most assistance during a pandemic.
Moving up the income ladder, the ability to spend increases with the amount of income. During a pandemic, however, those high-income groups would have less to spend on. (How many new couches can you buy?) Therefore, providing benefits to high-income groups through tax breaks would not be expected to generate increases in overall spending, with the excess funds merely salted away in a savings account.
At a time of distress, it is in everyone’s best interest to target policy for those cohorts that are most likely to spend any and all income received.
Finally, the recent spike in M2 growth has induced a discussion round the threat of runaway inflation due to monetary action taken by the central bank to stimulate accommodation as legislators have been unwilling to provide fresh fiscal stimulus.
The takeaway
But as the last figure illustrates, recessions are more likely to threaten the economy with deflation than inflation. The Fed knows how to squeeze inflation out of an economy. Deflation, on the other hand, has no easy or straightforward solution – think of the Depression.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
